Markets everywhere have fallen as the day nears when the Federal Reserve raises rates. Hardest hit have been emerging-market bonds

APART from citizens of Brazil and the rarefied folk that deal in international bonds, few will have heard of, much less care about, that country's dollar-denominated 11% bond, which matures on August 17th 2040. In fact, it is rather important. Since this is the country's benchmark bond and Brazil is the biggest debtor among emerging countries, it has become the benchmark bond for all emerging markets. Even by the exacting standards of such markets, Brazil's 11% '40 is stomach-churningly volatile. As a much-favoured play for investors fleeing small yields on American Treasuries, the price of the bond rose from 43 cents per dollar of face value in late 2002 to 120 cents in January, dragging yields from 26.7% to 9.5%. Since then the bond's price has fallen by 30% or so, and this week touched a low of 83 cents.

On top of domestic wobbles, the proximate cause of this latest fall in the Brazilian benchmark were worries that, as result of a series of strong economic statistics from America—the latest being robust employment numbers—and inflationary stirrings, the Federal Reserve will put up interest rates much sooner than the market had expected. It now thinks they will rise in June. The yield on ten-year Treasury bonds, which had fallen to 3.65% in March, climbed at one point this week to 4.8%.

Though extreme, the reaction of the Treasury-bond market (and other bond markets) to the threat of higher interest rates and creeping inflation was predictable enough. Less predictable, perhaps, has been the sharp fall in the price of riskier assets the world over.

Investors' biggest worry is that a rise in American rates will withdraw a crucial support from the many markets around the world that had risen vertiginously, helped up by the many who had wanted more bang for their buck than could be gained from popping it in the bank. Their fears have been doubled because many of these, hedge funds being the most obvious, had taken advantage of ultra-cheap borrowing to leverage these bets.

Betting with borrowed money worries many because, although it allows investors to make more when markets go their way, it multiplies their losses when they do not. Enforced liquidation—or the fear of it—has been partly responsible for markets' skid in recent weeks. That, after all, was what happened in 1994 when the Fed last raised rates sharply. And in 1998, Russia's default led to the near-collapse of Long-Term Capital Management, a hugely leveraged hedge fund, and caused huge losses for other leveraged investors.

These fears have been the main reason why stockmarkets have fallen lately—although spurting oil prices (see article) also frightened investors this week. America's S&P 500 is now down 5% from its recent high. European shares, too, have stumbled: the Eurotop 300, an index of the shares of leading companies, is 5.5% off its peak. Japan's Topix index, which had been driven up entirely by foreign buying in recent months (domestic investors have been selling all the way up) is now 8% below its high; on May 10th alone, it fell by almost 6%, before perking up later in the week.

These falls pale, however, when compared with those in emerging markets. An index of emerging-market shares compared by Morgan Stanley Capital International has fallen by about 16% from its peak in mid-April. In part, these woes reflect fears that China's demand for commodities, and hence commodity prices, will falter. If this happens, economies that rely on commodity exports will suffer. Stockmarkets in countries where interest-rate and commodity-price fears are combined, as they are in Latin America, have done especially badly. Argentina's and Brazil's are both down by a quarter from their highs.

And then there is emerging-market debt. As a uniquely poisonous cocktail, mixing fears of rising rates with high leverage and silly valuations, the market for such bonds is hard to beat. Last year, investors, especially leveraged ones, piled into emerging-market bonds as a splendid way to pick up yield. But as worries that rates will rise have mounted, a fall over the past few months has turned into a rout as the hot money has scrabbled to get out.

Déjà vu all over again

Anyone who buys the foreign debt issued by emerging countries takes two separate, though linked, punts. Since most bonds are denominated in dollars, what happens to American Treasury-bond yields has a big impact on their prices. But so do perceptions of how likely their issuers are to default. This risk is measured by the spread—dubbed the credit spread—that these bonds offer over Treasuries: the greater the risk, the higher this is.

Last year, the big money was made from falling credit spreads. From its peak in September 2002 to its trough early this year, the EMBI+, an index of these spreads tracked by J.P. Morgan, fell from 1,041 bps (basis points, or hundredths of a percentage point) over Treasuries, to 384 bps in early January.

This is a little curious. None of the top borrowers in emerging markets has an unsullied credit record. Brazil, the biggest borrower, defaulted in 1826, 1898, 1902, 1914, 1931, 1937 and 1983. Its neighbour, Argentina, another serial non-payer, is still in default to the tune of $100 billion or so, the biggest in history. Russia last defaulted (admittedly, only on its domestic debt) in 1998. Moreover, the riskiness of these issuers has fallen only slightly over the past year. Russia has benefited from high oil prices, and Latin American economies have been given a fillip by rising commodity prices. But the credit-worthiness of emerging-market issuers overall has not markedly improved.

True, yields were probably too generous in the autumn of 2002. But by the turn of this year they were ludicrously meagre, given the risks that investors run by lending money to countries with a habit of not repaying it. Prices have dropped since then, not only because Treasuries have fallen but also because credit spreads have widened dramatically as investors wake up to these risks. The spread of the EMBI+ rose from its low point in January to 569 bps this week.

Though prices subsequently recovered a bit, emerging debt probably has further to fall. The Fed's drip-feed of low interest rates and investors' ravenous appetite for risk enabled many emerging countries and companies in them (notably, Russian firms) to borrow remarkably cheaply in the capital markets, despite a multitude of deep-seated problems.

As interest rates wax and risk appetite wanes, investors are likely to focus on countries' problems, not their progress. Christian Stracke, an analyst at CreditSights, an independent bond-research firm, points out that many countries—Brazil, Turkey, and the Philippines among them—still need to borrow lots from abroad this year to finance their deficits. Indeed, he points out that at some $40 billion, Brazil's foreign-borrowing needs for the rest of this year are greater now than the $37.5 billion that it needed at the same stage of 2002. The 11% '40 will prove a good measure of investors' appetite.